Most large-scale macroeconomic models in use by major central banks use a so-called New Keynesian Phillips Curve (NKPC). It relates current inflation to expected future inflation and the cost pressures faced by firms, which in turn is related to the current level of output relative to potential — in other words, the degree of economic slack. So how useful is the concept of economic slack in explaining inflation in practice? Data support the idea of a relationship between the two, but nevertheless there are two difficulties: first, the nature of that relationship varies from year to year; and second, measurement difficulties mean it can be hard to exploit that relationship in real time. The chart below is derived from a fairly crude attempt to estimate a NKPC, and suggests a generally positive relationship:
However, in using estimates of the output gap to predict inflation, we implicitly assume there is a stable relationship between the quantity a firm is producing relative to normal levels, and its marginal cost of production. This is the case for traditional firms, but there are a growing number of firms which rely much more on intangible capital. It seems likely that the growing importance of intangible assets means that the proportion of output accounted for by firms with marginal cost curves that are either flat, or close to flat, is rising. Other things equal, this will make the output gap less useful as a concept, and prices (in aggregate) less responsive to fluctuations in demand.
Despite this, Fathom uses the output gap framework to argue that, as economies reopen in full, aggregate demand relative to potential is likely to rise sufficiently far to put significant upward pressure on inflation. Why? There are two reasons.
First, the starting point. During the pandemic, governments ordered whole industries to cease production, while simultaneously requiring their citizens to stop buying the products of those industries. Output and potential output shifted down in parallel by government decree. Hence, the output gap in the UK is unlikely to have changed much, at least in terms of what such a concept might tell us about the degree of inflationary pressure. This stands in contrast to many official estimates. The OECD, for example, suggest that the UK economy was operating at 8.8% below potential last year, having operated at 3.7% above potential in 2019.
Second, demand and supply will rise swiftly in parallel as economies reopen, which is where the dramatic response of both monetary and fiscal policy during the pandemic comes into play. The chart below compares UK GDP and UK factor incomes through the pandemic, with their behaviour through the global financial crisis of 2008/09.
The outcome of a government policy that provides households with incomes close to pre-pandemic levels, while simultaneously forbidding those households from purchasing many of the goods and services that they would normally purchase, is a substantial build up in savings.
Economic activity and inflation across the major economies will depend on how rapidly those excess savings pots are spent. In its February Monetary Policy Report, the Bank of England assumed that just 5% of excess savings built up by UK households is spent over the next three years. But it seems likely that households will spend more, since the savings are a rational, endogenous response to a very difficult set of circumstances. In Fathom’s latest forcasts, it is therefore assumed in the central case that some 10% of the excess savings pots were spent in the first two years of the forecast.
Because of this more bullish view of the propensity of households to spend their excess savings, Fathom’s forecasts for economic growth are stronger than those of most official forecasters. And with expenditure likely to be skewed towards more traditional forms of economic activity with clear capacity constraints — such as hospitality, travel and tourism — output gap approaches to the analysis of inflationary pressures are likely to bear fruit.
With the balance between aggregate demand and aggregate supply little changed during the pandemic, it is likely that cyclical factors will put upward pressure on inflation. What then? With high levels of debt, and asset prices supported by an expectation of near-zero interest rates more or less indefinitely, policymakers would be bold to tighten aggresively if inflation rose above target. It is more likely they will look through any inflation overshoot, relying on hard-won credibility to keep inflation expectations on track. The risk is that this gamble fails, ushering in a sustained period of higher inflation.
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